Once and Future Investment Banks
By Roy Smith, Kenneth Langone Professor of Entrepreneurship and Finance & Professor of Management Practice
The great thing about the investment banking industry is that it survives all its crises and endures. The not so great thing is that firms that comprise the industry do not.
When I joined Goldman Sachs in 1966, there were about 20 significant investment banks and ten major money center banks in the US, and another 15 or so in Europe. Since then all of these firms have either failed, merged or passed control to others – all except one: Goldman Sachs.
Some attribute Goldman Sachs’ survival to its simple, highly focused strategy of intermediating between institutional investors and corporations, and to its partnership culture.
But even Goldman Sachs has stared into the face of extinction on more than one occasion. It is not the avoidance of mishaps that has mattered the most, it has been the ability to survive and prosper amidst a half-century of massive change imposed on the industry by external forces, principally deregulation, globalization and technology. These drivers have been extremely powerful, and have included the change to negotiated rates on stock exchanges, the collapse of the gold standard and its replacement by floating exchange rates, the development of the euro-markets, rule 415 and shelf registrations that probably ended the era of exclusive relationships with clients, structured products, derivatives, the Internet, Emerging Markets, the repeal of Glass Steagall, and alternative markets and high-frequency trading. It’s a long list.
The chief consequence of all this has been an incredible increase in the quantity of securities outstanding in the world, now around $215 trillion, and the volume of trading in them. As welcome as this may be, it has come with an accompanying increase in competition, compression of spreads and the necessity to take on risk to preserve market shares.
We are now at the point where the industry is gathering itself together after the painful bursting of the second great financial bubble in a decade, which sent the investment banking industry into a cataclysm that either killed, or nearly killed, five of the top ten global players – Bear Stearns, UBS, Lehman, Merrill, and Citigroup. The survivors have been struggling for the past five years under the weight of difficult markets, heavily increased regulation and a raft of prosecutorial zeal and media criticism.
Wall Street is widely seen as being responsible for the bubbles that are thought to have set back the real economy and the prosperity and security of the American people by a decade. That is a very heavy charge that cannot be brushed off lightly. Wall Street’s struggles today only bring to mind the old notion that capitalism can only operate in a democracy with the consent of the people, as this is expressed in regulatory and enforcement policies carried out by their government representatives. Bankers may not like the image Wall Street now has, but they shouldn’t be surprised by it.
This image is reflected in the markets. As of the end of the of 2011, the average market to book ratio of the top ten global banks by market share was 0.50, and the average economic value added (i.e., ROE minus cost of equity capital) was negative 5.87%. Nine of the top ten reported negative EVA in 2011; their average EVA, however, had been negative for the preceding nine quarters.
We are, of course, in a down-cycle in capital market activity, but nevertheless, these are pretty pathetic numbers, suggesting the industry also has some serious, non-cyclical problems. By comparison, a group of five large global retail banks (Wells Fargo, HSBC, Royal Bank of Canada, Toronto Dominion, and Standard Chartered) were trading at 1.23 times book and EVA of plus 2.03%.
Indeed, when Moody’s announced in February that it may cut ratings of 17 capital market banks by from 1 to 3 notches, it said it was because of “more fragile funding conditions, wider credit spreads, increased regulatory burdens and more difficult operating conditions… that together with inherent vulnerabilities…and opacity of risk, have diminished the longer term profitability and growth prospects of these firms.”
Moody’s, no doubt, took into account the Basel Committee’s announcement last month that it calculates that if its Basel III standards that go into effect seven years from now were applied today, 212 large banks and other lenders would need an additional $640 billion of capital to meet them.
If Moody’s does what it says it might, then there will be only one of the top ten global investment bankers with an A1 rating, 4 with A2, two with A3, and three with Baa2 ratings -- only two notches above junk, an impossible position for a major bank with an active trading unit to be.
In the past, when the industry has been through tough times, it pursued one of three strategies – first, to cut costs, increase liquidity and hunker down until the storm cleared, usually within a couple of years at the most.
The second option was an intra-industry merger in which the acquirer would take over an acquiree for book value or less to get its top performers and clients, dumping everything else.
Or, the third option, a “strategic merger” with a big player outside the industry (Amex/Lehman; Sears/Dean Witter; Phibro/Salomon; GE/Kidder Peabody, Citigroup/Salomon; Credit Suisse/First Boston). None of these worked very well for either the acquired or the acquiring firm.
Today the options are fewer – all the banks have been hunkering down for at least the past four years, and the end is hardly in sight. It is hard to hang on to top talent under these conditions if they have options to move to hedge funds, private equity or boutiques, as many have done.
The merger options don’t work very well now either. Large banks are discouraged from making acquisitions by Dodd-Frank, and large nonbanks do not want to risk being made “systemically important” through an investment banking acquisition. In any case the uncertain future of many investment banks may put off all buyers other than Carl Icahn, and it’s not clear they want him as a “white knight.”
So, significant internal restructuring may be the only answer. Some of this is reengineering the business to lower risks and costs; but some of it is strategic. Recent events suggest a lot of this restructuring is already going on in terms of post-crisis rethinking of business models:
Under pressure from their governments, UBS and Credit Suisse are going to reduce their risk-weighted assets (most of which are in the investment bank) by more than 50%, which sounds like they will be bringing their trading businesses down to a minimum.
The British government has “ringfenced” its domestic banking businesses, which forces their investment banks (mainly Barclays) to be separately incorporated, managed, and financed with minimal assistance from the parent. That could be very tough, and may lead to a de-facto separation, or spinoff, of the investment bank.
Deutsche Bank, in recent moves, has acquired the rest of Deutsche Postbank, a retail bank, put its asset management business up for sale, and appointed co-CEOs, one for German business, one for the rest. Thus a future split up there may also be a possibility.
Citigroup is preparing to undo the last of the Travelers deal – once a landmark of the industry – by selling of the remaining parts of CitiHoldings, leaving only Citicorp to face the future. Whether it will turn in the direction of JP Morgan or Wells Fargo as it repositions itself is not clear, but wholesale banking nearly killed Citicorp in the 1980s and again after being acquired by Sandy Weill, so maybe it would be better off sticking to retail banking, both domestic and international, for its next act.
Morgan Stanley has put itself in the hands of another former McKinsey man, a retail finance expert, who seems determined to turn the firm into a modern version of the old Merrill Lynch. The idea seems to be to thin out the firm’s exposure to capital requirements.
Bank of America is still a $2 trillion asset mess, still hostage to its Countrywide acquisition. How Merrill Lynch can fit into its future is hard to say, but the bank is bound to have to unbundle itself, and Merrill is one of the viable entities it could sell or spin off. But the longer Merrill stays inside the belly of the whale, the more the digestive juices are breaking it down.
JP Morgan seems to be the market’s choice for having its act together and being able to absorb the new regulatory burden better than most. But it is still trading only at book value, as compared to 1.3 times at Wells Fargo. The bank seems to be manageable under Jamie Dimon, but what happens after he leaves?
Goldman Sachs perhaps is the most affected by regulatory changes because of their potential impact on the firm’s essential trading businesses. Nevertheless Lloyd Blankfein has said that to remain successful and independent in the past, Goldman Sachs has had to adapt to its times and circumstances many times, and it will do so again.
Meanwhile, global capital markets continue to be large, complex and filled with opportunities. But the leading firms have to reengineer themselves to adapt to the new conditions that reregulation has imposed: Look for downsizing, spin offs and greater focus on distributing securities rather than owning them, not for more big mergers and fortress balance sheets.